Photographer: Qilai Shen/Bloomberg

Emerging-Market Assets Roar Back to Life

  • Short interest in largest stock, bond ETFs slumped to about 2%
  • Morgan Stanley says growth pickup needed for rally to continue

The best rally in emerging-market stocks and bonds in seven years is sending bears back into hibernation.

Short interest in the largest exchange-traded fund tracking developing-nation dollar-denominated bonds has fallen to 2.2 percent of shares outstanding, near the lowest level since 2012, from 13 percent in mid-February, according to data compiled by Bloomberg and Markit Ltd. Bearish bets on BlackRock Inc.’s $26 billion emerging-market stock ETF have tumbled to around a 1 1/2-year low of 2.9 percent, from 15 percent in January.

Developing-market assets this month have extended a rally started in March as China’s economy stabilized, commodity prices rebounded and the Federal Reserve signaled it would go slow in raising U.S. interest rates. Traders added more than $1 billion to U.S.-traded emerging-market stock and bond ETFs this month through April 15, pushing the total inflow this year to $4.5 billion, following an exodus in 2015, data compiled by Bloomberg show.

“We’ve passed the low point,” Jens Nystedt, a New York-based emerging-market debt manager at Morgan Stanley Investment Management, which oversees more than $400 billion, said by phone. “EM fixed income is still cheap, even after the rally.”

BlackRock ETFs

BlackRock’s $6 billion iShares ETF tracking emerging-market dollar bonds has gained 6.5 percent this year, double the return of U.S. Treasuries. The stock ETF rose to a five-month high last week, extending the advance to 22 percent from its low in January.

Emerging-market dollar debt last week yielded 3.9 percentage more than U.S. Treasuries on average, compared with five-year average of 3.4 percentage points, according to data compiled by JPMorgan Chase & Co. In the local-currency bonds, the rally pushed the yields to a one-year low of 6.4 percent.

With about 20 percent of the $44 trillion bonds in the global benchmarks trading with negative yields, investors will “increasingly seek out emerging
markets debt” for higher returns, according to Pierre-Yves Bareau, chief investment officer of emerging markets debt at JP Morgan Asset Management.

“This is a good time to be tactically invested” in emerging-market debt, “although we remain wary of long-term downside risks,” including impact from lower oil prices and deterioration of governments balance sheets, Bareau wrote in a report Monday.

Growth Outlook

While investors are turning less bearish, developing economies need to show more signs of growth momentum for the rally to continue, according to Nystedt, who favors the South African rand and Mexican peso.

“To say that this is an outright inflection point, we need to see one missing piece of this EM rally: an improvement of the underlying emerging-market fundamentals,” he said.

The International Monetary Fund last week lowered its 2016 growth projection for developing countries to 4.1 percent, from 4.3 percent in October. It still points to a pickup from 4 percent from 2015, which was the slowest expansion since 2009. Chinese data last week showed improvements in exports industrial output and retail sales in March, suggesting the world’s second-largest economy is stabilizing.

Rally Pause

Stocks and currencies retreated on Monday after talks between major oil producers ended in Doha without any agreement on limiting output. The MSCI Emerging Markets Index of shares snapped a seven-day rally to drop 0.2 percent as of 10:37 a.m. in London. Brazil’s Ibovespa index was little changed as lower house of Congress voted in favor of impeaching President Dilma Rousseff.

“While lower oil prices could be a threat, it’s definitely not the same situation we had in January,” said Rajeev De Mello, who oversees about $10 billion as the head of Asian fixed income at Schroder Investment Management Ltd. in Singapore. “We’ve a more positive situation in China. We have the Fed, which is very dovish anyway.”

While Schroder has become cautious after the recent rally, it still has a “constructive” bias toward emerging markets, according to De Mello. Deutsche Asset Management is warming up to equities and dollar-denominated corporate debt of developing nations, and expects oil prices to rally over the next 12 months, Sean Taylor, chief investment officer for Asia Pacific emerging markets, said in a briefing in Singapore.

Accommodative Policies

Bond investors at Goldman Sachs Asset Management concurred that the “accommodative” global monetary policies are “positive” for “selective exposure” to emerging-market debt. China poses a risk as its monetary fiscal stimulus to shore up growth threatens the long-term stability in its financial system, the fixed-income group said in its outlook report for the second quarter. They’re hedging that risk through credit-default swaps and taking a short position in Asian currencies versus the Russian ruble.

“China appears to be prioritizing its growth target rather than reforms,” the team wrote in the research note. “In the near-term, we think this is supportive for financial markets but liquidity-fueled debt growth seems unsustainable and could create bigger risks over the longer term.”

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